New measures to shore up the markets are coming so fast and furious that it is becoming hard to keep track of them. What most people do not realize is that they produced some not-very-pretty unintended consequences. As we discussed (courtesy reader Lune) at the time:
1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.
2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.
Note the spike in agency spreads and bankruptcy of Carlyle helped precipitate the run on Bear.
In fact, as Richard Bookstaber discussed at length in his book, Demon of Our Own Design, this sort of unintended consequence is precisely what you’d expect to see in a tightly coupled system, such are our financial system. Tight coupling occurs when processes move from step to step so rapidly that intervention is well-nigh impossible. Bear Stearns and Lehman are classic examples. A downgrade of their debt beyond a certain level meant that their counterparties could no longer trade with them, because that exposure would get them downgraded too. Thus a move (or threatened move) beyond a trigger point kicked off a sequence of unstoppable events.
One possible consequence is that hedge funds forced to exit positions by the SEC ban on short-selling might take losses big enough to lead to a run of the fund, forcing liquidation of positions. That rapid selling could produce distressed prices, and in a worst-case scenario, brokers could take losses if collateralized positions fell in value and hedge funds were unable to meet margin calls.
Note Morgan Stanley and Goldman are far and away the biggest prime brokers.
John Hempton sets forth another unintended consequence which is more certain to happen and broader in its impact and puts none to fine a point on it in his post title, “SEC Tries to Bankrupt Wall Street“:
Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.
That cash was not available to me – it was pledged to whoever provided the stock to remove or reduce the risk that the stock won’t be returned.
That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).
Now there are a few hundred billion of short-sales out there. Probably more than normal – but a lot in almost all markets.
And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.
If you ban short-selling those balances will taken away from Wall Street brokers.
That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.
So I conclude that the SEC in their “infinite wisdom” are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.
The only reason the damage might not be as broad-scale as Hempton fears is that the “temporary” ban is on shorting financial stock. Oh wait, financial represented (until they started hitting the rocks) 40% of S&P earnings.
And there is something far simpler that the SEC could do. Just re-implement the uptick rule (it means you can short only when the last sale price was above the immediately prior sale). That rule comported itself well for over 50 years but for some unfathomable reason (no doubt at the behest of Wall Street) was eliminated b the SEC.
Originally published at Naked Capitalism and reproduced here with the author’s permission.